Unemployment and the

Labour Market
 Unemployment is the macroeconomic problem that affects people
most directly and severely. For most people, the loss of a job means a
reduced living standard and psychological distress. It is no surprise
that unemployment is a frequent topic of political debate and that
politicians often claim that their proposed policies would help create
jobs. While the issue is perennial, it rose to particular prominence in
the aftermath of the financial crisis and recession of 20082009,
when the unemployment rate lingered around 9 percent for several
years before drifting down to about 6 percent in 2014.
 Economists study unemployment to identify its causes and to help
improve the public policies that affect the unemployed. Some of
these policies, such as job training programs, help people find
employment. Others, such as unemployment insurance, alleviate
some of the hardships that the unemployed face. Still other policies
affect the prevalence of unemployment inadvertently. Laws
mandating a high minimum wage, for instance, are widely thought to
raise unemployment among the least skilled and least experienced
members of the labour force.
 Our discussions of the labour market so far have ignored
unemployment. In particular, the model of national income was built
with the assumption that the economy is always at full employment.
In reality, not everyone in the labour force has a job all the time: in all
free-market economies, at any moment, some people are
unemployed.
There is always some unemployment. The natural rate of
unemployment is the average level around which the unemployment
rate fluctuates. (The natural rate of unemployment for any particular
month is estimated here by averaging all the unemployment rates
from ten years earlier to ten years later. Future unemployment rates
are set at 5.5 percent.)
Job Loss, Job Finding, and the Natural
Rate of Unemployment
Every day some workers lose or quit their jobs, and some unemployed
workers are hired. This perpetual ebb and flow determines the fraction of
the labour force that is unemployed. In this section we develop a model of
labour-force dynamics that shows what determines the natural rate of
unemployment.
We start with some notation. Let L denote the labour force, E the number
of employed workers, and U the number of unemployed workers. Because
every worker is either employed or unemployed, the labour force is the
sum of the employed and the unemployed:
L = E + U.
In this notation, the rate of unemployment is U/L.
 To see what factors determine the unemployment rate, we assume
that the labour force L is fixed and focus on the transition of
individuals in the labour force between employment E and
unemployment U. This is illustrated in Figure 7-2. Let s denote the
rate of job separation, the fraction of employed individuals who lose
or leave their jobs each month. Let f denote the rate of job finding,
the fraction of unemployed individuals who find a job each month.
Together, the rate of job separation s and the rate of job finding f
determine the rate of unemployment.
 If the unemployment rate is neither rising nor fallingthat is, if the
labour market is in a steady statethen the number of people finding
jobs fU must equal the number of people losing jobs sE. We can write
the steady-state condition as
fU = sE.
We can use this equation to find the steady-state unemployment
rate. From our definition of the labour force, we know that E = L - U;
that is, the number of employed equals the labour force minus the
number of unemployed. If we substitute (L - U ) for E in the steady-
state condition, we find
 This equation shows that the steady-state rate of unemployment U/L
depends on the rates of job separation s and job finding f. The higher
the rate of job separation, the higher the unemployment rate. The
higher the rate of job finding, the lower the unemployment rate.
Heres a numerical example. Suppose that 1 percent of the employed
lose their jobs each month (s = 0.01). This means that the average
spell of employment lasts 1/0.01, or 100 months, about 8 years.
Suppose further that 20 percent of the unemployed find a job each
month ( f = 0.20), so that the average spell of unemployment last 5
months. Then the steady-state rate of unemployment is
The rate of unemployment in this example is about 5 percent. This
simple model of the natural rate of unemployment has an important
implication for public policy. Any policy aimed at lowering the natural
rate of unemployment must either reduce the rate of job separation or
increase the rate of job finding. Similarly, any policy that affects the
rate of job separation or job finding also changes the natural rate of
unemployment.
 Although this model is useful in relating the unemployment rate to
job separation and job finding, it fails to answer a central question:
Why is there unemployment in the first place? If a person could
always find a job quickly, then the rate of job finding would be very
high and the rate of unemployment would be near zero. This model
of the unemployment rate assumes that job finding is not
instantaneous, but it fails to explain why. In the next two sections, we
examine two underlying reasons for unemployment: job search and
wage rigidity.
Job Search and Frictional Unemployment
One reason for unemployment is that it takes time to match workers
and jobs. The equilibrium model of the aggregate labour market
assumes that all workers and all jobs are identical and, therefore, that
all workers are equally well suited to all jobs. If this were true and the
labour market were in equilibrium, then a job loss would not cause
unemployment: a laid-off worker would immediately find a new job
at the market wage.
 In fact, workers have different preferences and abilities, and jobs have
different attributes. Furthermore, the flow of information about job
candidates and job vacancies is imperfect, and the geographic
mobility of workers is not instantaneous. For all these reasons,
searching for an appropriate job takes time and effort, and this tends
to reduce the rate of job finding. Indeed, because different jobs
require different skills and pay different wages, unemployed workers
may not accept the first job offer they receive. The unemployment
caused by the time it takes workers to search for a job is called
frictional unemployment.
Causes of Frictional Unemployment
Some frictional unemployment is inevitable in a changing economy.
For many reasons, the types of goods that firms and households
demand vary over time. As the demand for goods shifts, so does the
demand for the labour that produces those goods. The invention of
the personal computer, for example, reduced the demand for
typewriters and the demand for labour by typewriter manufacturers.
At the same time, it increased the demand for labour in the
electronics industry.
 Similarly, because different regions produce different goods, the
demand for labour may be rising in one part of the country and falling
in another. An increase in the price of oil may cause the demand for
labour to rise in oil-producing states such as Texas, but because
expensive oil means expensive gasoline, it makes driving less
attractive and may decrease the demand for labour in auto-producing
states such as Michigan. Economists call a change in the composition
of demand among industries or regions a sectoral shift. Because
sectoral shifts are always occurring, and because it takes time for
workers to change sectors, there is always frictional unemployment.
 Sectoral shifts are not the only cause of job separation and frictional
unemployment. In addition, workers find themselves unexpectedly
out of work when their firms fail, when their job performance is
deemed unacceptable, or when their particular skills are no longer
needed. Workers also may quit their jobs to change careers or to
move to different parts of the country. Regardless of the cause of the
job separation, it will take time and effort for the worker to find a new
job. As long as the supply and demand for labour among firms is
changing, frictional unemployment is unavoidable.
Public Policy and Frictional Unemployment
Many public policies seek to decrease the natural rate of
unemployment by reducing frictional unemployment. Government
employment agencies disseminate information about job vacancies to
match jobs and workers more efficiently. Publicly funded retraining
programs are designed to ease the transition of workers from
declining to growing industries. If these programs succeed at
increasing the rate of job finding, they decrease the natural rate of
unemployment.
 Other government programs inadvertently increase the amount of
frictional unemployment. One of these is unemployment insurance.
Under this program, unemployed workers can collect a fraction of
their wages for a certain period after losing their jobs. Although the
precise terms of the program differ from year to year and from state
to state, a typical worker covered by unemployment insurance in the
United States receives 50 percent of her former wages for 26 weeks.
In many European countries, unemployment-insurance programs are
significantly more generous.
 By softening the economic hardship of unemployment,
unemployment insurance increases the amount of frictional
unemployment and raises the natural rate. The unemployed who
receive unemployment-insurance benefits are less pressed to search
for new employment and are more likely to turn down unattractive
job offers. Both of these changes in behaviour reduce the rate of job
finding. In addition, because workers know that their incomes are
partially protected by unemployment insurance, they are less likely to
seek jobs with stable employment prospects and are less likely to
bargain for guarantees of job security. These behavioural changes
raise the rate of job separation.
 That unemployment insurance raises the natural rate of
unemployment does not necessarily imply that the policy is ill
advised. The program has the benefit of reducing workers
uncertainty about their incomes. Moreover, inducing workers to
reject unattractive job offers may lead to better matches between
workers and jobs. Evaluating the costs and benefits of different
systems of unemployment insurance is a difficult task that continues
to be a topic of much research.
 Economists often propose reforms to the unemployment-insurance
system that would reduce the amount of unemployment. One
common proposal is to require a firm that lays off a worker to bear
the full cost of that workers unemployment benefits. Such a system is
called 100 percent experience rated, because the rate that each firm
pays into the unemployment-insurance system fully reflects the
unemployment experience of its own workers. Most current
programs are partially experience rated. Under this system, when a
firm lays off a worker, it is charged for only part of the workers
unemployment benefits; the remainder comes from the programs
general revenue. Because a firm pays only a fraction of the cost of the
unemployment it causes, it has an incentive to lay off workers when
its demand for labour is temporarily low. By reducing that incentive,
the proposed reform may reduce the prevalence of temporary layoffs.
CASE STUDY: Unemployment
Insurance and the Rate of
Job Finding
 Many studies have examined the effect of unemployment insurance
on job search. The most persuasive studies use data on the
experiences of unemployed individuals rather than economy-wide
rates of unemployment. Individual data often yield sharp results that
are open to few alternative explanations.
One study followed the experience of individual workers as they used
up their eligibility for unemployment-insurance benefits. It found that
when unemployed workers become ineligible for benefits, they are
more likely to find jobs. In particular, the probability of a person
finding a job more than doubles when his or her benefits run out.
One possible explanation is that an absence of benefits increases the
search effort of unemployed workers. Another possibility is that
workers without benefits are more likely to accept job offers they
would otherwise decline because of low wages or poor working
conditions.
 Additional evidence on how economic incentives affect job search
comes from an experiment that the state of Illinois ran in 1985.
Randomly selected new claimants for unemployment insurance were
each offered a $500 bonus if they found employment within 11
weeks. The subsequent experience of this group was compared to
that of a control group not offered the incentive. The average
duration of unemployment for the group offered the $500 bonus was
17.0 weeks, compared to 18.3 weeks for the control group. Thus, the
prospect of earning the bonus reduced the average spell of
unemployment by 7 percent, suggesting that more effort was
devoted to job search. This experiment shows clearly that the
incentives provided by the unemployment-insurance system affect
the rate of job finding.
Real-Wage Rigidity and Structural
Unemployment
A second reason for unemployment is wage rigiditythe failure of
wages to adjust to a level at which labour supply equals labour
demand. In the equilibrium model of the labour market, the real
wage adjusts to equilibrate labour supply and labour demand. Yet
wages are not always flexible. Sometimes the real wage is stuck above
the market-clearing level.
Figure 7-3 shows why wage rigidity leads to unemployment. When
the real wage is above the level that equilibrates supply and demand,
the quantity of labour supplied exceeds the quantity demanded.
Firms must in some way ration the scarce jobs among workers. Real-
wage rigidity reduces the rate of job finding and raises the level of
unemployment.
 The unemployment resulting from wage rigidity and job rationing is
sometimes called structural unemployment. Workers are
unemployed not because they are actively searching for the jobs that
best suit their individual skills but because there is a fundamental
mismatch between the number of people who want to work and the
number of jobs that are available. At the going wage, the quantity of
labour supplied exceeds the quantity of labour demanded; many
workers are simply waiting for jobs to open up.
 To understand wage rigidity and structural unemployment, we must
examine why the labour market does not clear. When the real wage
exceeds the equilibrium level and the supply of workers exceeds the
demand, we might expect firms to lower the wages they pay.
Structural unemployment arises because firms fail to reduce wages
despite an excess supply of labour. We now turn to three causes of
this wage rigidity: minimum-wage laws, the monopoly power of
unions, and efficiency wages.
Minimum-Wage Laws
The government causes wage rigidity when it prevents wages from
falling to equilibrium levels. Minimum-wage laws set a legal minimum
on the wages that firms pay their employees. Since the passage of the
Fair labour Standards Act of 1938, the U.S. federal government has
enforced a minimum wage that has usually been between 30 and 50
percent of the average wage in manufacturing. In addition, many
states enact minimum wages that are higher than the federal one: for
example, in 2014, when the federal minimum wage was $7.25 per
hour, California had a minimum wage of $9.00 per hour. For most
workers, the minimum wage is not binding, because they earn well
above the legislated minimum.
 Yet for some workers, especially the unskilled and inexperienced, the
minimum wage raises their wage above its equilibrium level and,
therefore, reduces the quantity of their labour that firms demand.
Economists believe that the minimum wage has its greatest impact on
teenage unemployment. The equilibrium wages of teenagers tend to
be low for two reasons.
First, because teenagers are among the least skilled and least
experienced members of the labour force, they tend to have low
marginal productivity.
Second, teenagers often take some of their compensation in the
form of on-the-job training rather than direct pay.
 An internship is a classic example of training offered in place of
wages. For both these reasons, the wage at which the supply of
teenage workers equals the demand is low. The minimum wage is
therefore more often binding for teenagers than for others in the
labour force.
Many economists have studied the impact of the minimum wage on
teenage employment. These researchers compare the variation in the
minimum wage over time with the variation in the number of
teenagers with jobs. These studies find that a 10 percent increase in
the minimum wage reduces teenage employment by 1 to 3 percent.
 The minimum wage is a perennial source of political debate.
Advocates of a higher minimum wage view it as a way to raise the
income of the working poor. Certainly, the minimum wage provides
only a meager standard of living: in the United States, a single parent
with one child working full time at a minimum-wage job would fall
below the official poverty level for a family of that size. Although
minimum-wage advocates often admit that the policy causes
unemployment for some workers, they argue that this cost is worth
bearing to raise others out of poverty.
 Opponents of a higher minimum wage claim that it is not the best
way to help the working poor. They contend not only that the
increased labour costs raise unemployment but also that the
minimum wage is poorly targeted. Many minimum wage earners are
teenagers from middle-class homes working for discretionary
spending money, rather than heads of households working to support
their families.
 Many economists and policymakers believe that tax credits are a
better way to increase the incomes of the working poor. The earned
income tax credit is an amount that poor working families are allowed
to subtract from the taxes they owe. For a family with very low
income, the credit exceeds its taxes, and the family receives a
payment from the government. Unlike the minimum wage, the
earned income tax credit does not raise labour costs to firms and,
therefore, does not reduce the quantity of labour that firms demand.
It has the disadvantage, however, of reducing the governments tax
revenue.
CASE STUDY: The Characteristics
of Minimum-Wage Workers
 Who earns the minimum wage? The question can be answered using
the Current Population Survey, the labour-market survey used to
calculate the unemployment rate and many other statistics. In 2014,
the Bureau of labour Statistics released a report describing the
workers who earned at or below the minimum wage in 2013, when
the prevailing minimum wage was $7.25 per hour. Here is a summary:
 About 76 million American workers are paid hourly, representing 59
percent of all wage and salary workers. Of these workers, 1.5 million
reported earning exactly the prevailing minimum wage, and another
1.8 million reported earning less. A reported wage below the
minimum is possible because some workers are exempt from the
statute (newspaper delivery workers, for example), because
enforcement is imperfect, and because some workers round down
when reporting their wages on surveys.
Minimum-wage workers are more likely to be women than men.
About 3 percent of men and 5 percent of women reported wages at
or below the prevailing federal minimum.
 Minimum-wage workers tend to be young. About half of all hourly-
paid workers earning the minimum wage or less were under age 25.
Among teenagers, about 20 percent earned the minimum wage or
less, compared with about 3 percent of workers age 25 and over.
Minimum-wage workers tend to be less educated. Among hourly-paid
workers age 16 and over, about 10 percent of those without a high
school diploma earned the minimum wage or less, compared with 4
percent of those with a high school diploma and 2 percent of those
with a college degree.
 Minimum-wage workers are more likely to be working part time.
Among part-time workers (those who usually work less than 35 hours
per week), 10 percent were paid the minimum wage or less,
compared to 2 percent of full-time workers.
The industry with the highest proportion of workers with reported
hourly wages at or below the minimum wage was leisure and
hospitality (about 19 percent). Just over one-half of all workers paid
at or below the minimum wage were employed in this industry,
primarily in food services and drinking places. For many of these
workers, tips supplement the hourly wages received.
 These facts by themselves do not tell us whether the minimum wage
is a good or bad policy, or whether it is too high or too low. But when
evaluating any public policy, it is useful to keep in mind those
individuals who are affected by it.
Unions and Collective Bargaining
A second cause of wage rigidity is the monopoly power of unions.
Table 7-1 shows the importance of unions in several major countries.
In the United States, only 13 percent of workers have their wages set
through collective bargaining. In most European countries, unions
play a much larger role.
The wages of unionized workers are determined not by the
equilibrium of supply and demand but by bargaining between union
leaders and firm management. Often, the final agreement raises the
wage above the equilibrium level and allows the firm to decide how
many workers to employ. The result is a reduction in the number of
workers hired, a lower rate of job finding, and an increase in
structural unemployment.
 Unions can also influence the wages paid by firms whose workforces
are not unionized because the threat of unionization can keep wages
above the equilibrium level. Most firms dislike unions. Unions not
only raise wages but also increase the bargaining power of labour on
many other issues, such as hours of employment and working
conditions. A firm may choose to pay its workers high wages to keep
them happy and discourage them from forming a union.
 The unemployment caused by unions and by the threat of
unionization is an instance of conflict between different groups of
workersinsiders and outsiders. Those workers already employed by
a firm, the insiders, typically try to keep their firms wages high. The
unemployed, the outsiders, bear part of the cost of higher wages
because at a lower wage they might be hired. These two groups
inevitably have conflicting interests. The effect of any bargaining
process on wages and employment depends crucially on the relative
influence of each group.
 The conflict between insiders and outsiders is resolved differently in
different countries. In some countries, such as the United States,
wage bargaining takes place at the level of the firm or plant. In other
countries, such as Sweden, wage bargaining takes place at the
national levelwith the government often playing a key role. Despite
a highly unionized labour force, Sweden has not experienced
extraordinarily high unemployment throughout its history. One
possible explanation is that the centralization of wage bargaining and
the role of the government in the bargaining process give more
influence to the outsiders, which keeps wages closer to the
equilibrium level.
Efficiency Wages
Efficiency-wage theories propose a third cause of wage rigidity in
addition to minimum-wage laws and unionization. These theories
hold that high wages make workers more productive. The influence of
wages on worker efficiency may explain the failure of firms to cut
wages despite an excess supply of labour. Even though a wage
reduction would lower a firms wage bill, it would alsoif these
theories are correctlower worker productivity and the firms profits.
 Economists have proposed various theories to explain how wages
affect worker productivity. One efficiency-wage theory, which is
applied mostly to poorer countries, holds that wages influence
nutrition. Better-paid workers can afford a more nutritious diet, and
healthier workers are more productive. A firm may decide to pay a
wage above the equilibrium level to maintain a healthy workforce.
Obviously, this consideration is not important for employers in
wealthier countries, such as the United States and most of Europe,
because the equilibrium wage is well above the level necessary to
maintain good health.
 A second efficiency-wage theory, which is more relevant for
developed countries, holds that high wages reduce labour turnover.
Workers quit jobs for many reasonsto accept better positions at
other firms, to change careers, or to move to other parts of the
country. The more a firm pays its workers, the greater is their
incentive to stay with the firm. By paying a high wage, a firm reduces
the frequency at which its workers quit, thereby decreasing the time
and money spent hiring and training new workers.
 A third efficiency-wage theory holds that the average quality of a
firms workforce depends on the wage it pays its employees. If a firm
reduces its wage, the best employees may take jobs elsewhere,
leaving the firm with inferior employees who have fewer alternative
opportunities. Economists recognize this unfavorable sorting as an
example of adverse selectionthe tendency of people with more
information (in this case, the workers, who know their own outside
opportunities) to self-select in a way that disadvantages people with
less information (the firm). By paying a wage above the equilibrium
level, the firm may reduce adverse selection, improve the average
quality of its workforce, and thereby increase productivity.
 A fourth efficiency-wage theory holds that a high wage improves
worker effort. This theory posits that firms cannot perfectly monitor
their employees work effort and that employees must themselves
decide how hard to work. Workers can choose to work hard, or they
can choose to shirk and risk getting caught and fired. Economists
recognize this possibility as an example of moral hazardthe
tendency of people to behave inappropriately when their behavior is
imperfectly monitored. The firm can reduce the problem of moral
hazard by paying a high wage. The higher the wage, the greater the
cost to the worker of getting fired. By paying a higher wage, a firm
induces more of its employees not to shirk and thus increases their
productivity
 Although these four efficiency-wage theories differ in detail, they
share a common theme: because a firm operates more efficiently if it
pays its workers a high wage, the firm may find it profitable to keep
wages above the level that balances supply and demand. The result of
this higher-than-equilibrium wage is a lower rate of job finding and
greater unemployment.
CASE STUDY: Henry Fords $5
Workday
 In 1914 the Ford Motor Company started paying its workers $5 per
day. The prevailing wage at the time was between $2 and $3 per day,
so Fords wage was well above the equilibrium level. Not surprisingly,
long lines of job seekers waited outside the Ford plant gates hoping
for a chance to earn this high wage.
What was Fords motive? Henry Ford later wrote, We wanted to pay
these wages so that the business would be on a lasting foundation.
We were building for the future. A low wage business is always
insecure. . . . The payment of five dollars a day for an eight hour day
was one of the finest cost-cutting moves we ever made.
 From the standpoint of traditional economic theory, Fords explanation
seems peculiar. He was suggesting that high wages imply low costs. But
perhaps Ford had discovered efficiency-wage theory. Perhaps he was using
the high wage to increase worker productivity.
Evidence suggests that paying such a high wage did benefit the company.
According to an engineering report written at the time, The Ford high
wage does away with all the inertia and living force resistance. . . . The
workingmen are absolutely docile, and it is safe to say that since the last
day of 1913, every single day has seen major reductions in Ford shops
labour costs. Absenteeism fell by 75 percent, suggesting a large increase in
worker effort. Alan Nevins, a historian who studied the early Ford Motor
Company, wrote, Ford and his associates freely declared on many
occasions that the high wage policy had turned out to be good business. By
this they meant that it had improved the discipline of the workers, given
them a more loyal interest in the institution, and raised their personal
efficiency.